Indexed Annuities, Better Read the Fine Print

Indexed Annuities are a Bad Deal

I found a website the other day that promises to teach you about indexed annuities in seven free lessons on “strategies the rich use to buy indexed annuities.” (Notice they don’t say “benefit”.) The lessons cover the basics of fixed indexed annuities, so-called safety nets, strategies and concepts, planning tools, and a demo on how to choose the right mix of annuities.

The lessons aren’t openly available – you have to register with your name, phone number, email, age, state, goals and concerns before you have access to the lessons. The site is geared toward retirees looking for income, growth and preservation of principal. The single page of this website also includes testimonials from three retirees who implemented the suggested strategy. Without registering for the site, I can’t tell you for sure whether or not the company who gives this training for free then conveniently has products to sell you to fulfill your strategy. Perhaps this .com company is providing this information simply out of the kindness of its heart. Hmm.

What is an Indexed Annuity, Anyway?

An indexed annuity is a variation of the fixed annuity. Fixed annuities pay interest on the principal. The minimum rate of interest is stated in the contract, but depending on market conditions to fund the interest payments and the interest rate needed to be competitive in the marketplace, the interest rate can be higher than the minimum. Usually not by much, though.

Indexed annuities are more complicated and generally imply you have the opportunity to receive a higher interest rate than with a traditional fixed annuity. Fixed indexed annuities also pay interest. But the rate is tied to the performance of an index, such as the S&P 500. The sales pitch for an indexed annuity says that you can participate in market upswings with no downside risk. Sounds like heaven, doesn’t it.

You often have multiple indexes to choose from, and sometimes can even choose to use more than one index, and can assign different percentages of the principal to each index chosen. For simplicity, let’s choose one index, the S&P 500 index I mentioned before.

The interest credited to your account is actually determined by participation rates, caps and calculated values. The participation rate is the percentage of growth that is actually used in the calculation. A 75% participation rate means that with a 20% return on the S&P 500, only 15% would be used in the calculation of interest. If the S&P returned 4%, only 3% would be used in the calculation.

But that’s not all. You will also be subject to a cap. The cap is the maximum amount of interest that can be credited to your account. Say you have a 7% cap. When the return on the index is below the cap rate, only the participation rate applies. So if the S&P returned 4%, with the 75% rate, you’d receive a 3% interest credit.

What if the S&P returned 20%, our other example? Again, with the 75% participation rate, the applicable interest rate drops to 15%. Then the cap kicks in, dropping the rate to the 7% cap. So even though the S&P 500 did 20%, you only see a 7% return in your annuity account. That’s 13% you lost out on.

What happens if the return of the S&P 500 was negative? Then you receive nothing. This is because indexed annuities have a zero floor – zero interest is paid when the return of the index is negative.

That’s not all. You also have to choose the option of how the return of the index is calculated. No, it isn’t what CNBC reports. CNBC may say that the S&P 500 index rose by 20% in the last year. However, the index annuity calculates the return based on one of three methods – point to point, averaging, or monthly sum. You have to choose one, just like you choose the index.

In the point to point method, the indexed annuity looks at the value of the index chosen on a given day, usually the contract date, and then compares it to the value on a future date, usually one year later. In the averaging method, the annuity looks at the value every day and takes the average value for that year, and then compares it to the average value from the previous year. In the monthly sum method, monthly values are added then divided by 12, then compared year over year. Values also are usually subject to caps.

Protection from Downside Risk

But wait, oh Wiser advisor, I don’t see any downside risk. If the market tanks, I don’t lose any money, because I have guarantee of principal. Yes. This is a great selling point for the indexed annuity provider and seller. However, you pay for this privilege. You will be subject to surrender charges, sometimes upwards of 10%, for a period of upwards of 10 years. If your desire is to not lose money, and even earn a little, you’d be better off with a 5-year CD paying a guaranteed rate of interest for a smaller lock-in period.

Why We Don’t Like Indexed Annuities

Indexed annuities are complicated. I’m a financial advisor. I even used to sell indexed annuities for another firm before I wised up. And still every time I run across a client who has an indexed annuity and is wondering what he can do with it, I have to study the darn thing extensively to fully understand it. And virtually every time, we can’t do anything with it until the surrender charge period is over.

Indexed annuities are also not fair to you. The indexed annuity seller makes a whole lot of money off of you when you purchase it. In return you get limited upside potential, and even zero growth potential in negative years. And you can’t get out of it for a significant period of time without negative impacts. The lack of downside risk is not worth what you pay for it.